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HedgingHedginginin
Islamic FinanceIslamic Finance
HedgingHedginginin
Islamic FinanceIslamic Finance
Sami Al-SuwailemSafar 1427 - March 2006
Sami Al-SuwailemSafar 1427 - March 2006
Hedging 2
ObjectivesObjectivesObjectivesObjectivesExplore dimensions of riskDevelop criteria for acceptable risksOutline strategy for product designDerive Islamic instruments for hedging
Explore dimensions of riskDevelop criteria for acceptable risksOutline strategy for product designDerive Islamic instruments for hedging
Hedging 3
State of RiskState of RiskState of RiskState of RiskMarkets are becoming more volatileEconomic instabilities are risingSolutions?
Markets are becoming more volatileEconomic instabilities are risingSolutions?
Hedging 4
Dow JonesDow JonesDow JonesDow Jones
0
50
100
150
200
250
300
02/ 01/ 1990 02/ 01/ 1993 02/ 01/ 1996 02/ 01/ 1999 02/ 01/ 2002 02/ 01/ 2005
Hedging 5
CommoditiesCommoditiesCommoditiesCommodities
0
20
40
60
80
100
120
140
160
December-91
J uly-93 J anuary-95
J uly-96 J anuary-98
J uly-99 J anuary-01
J uly-02 J anuary-04
J uly-05
Hedging 6
Currencies: USDCurrencies: USDCurrencies: USDCurrencies: USD
0
20
40
60
80
100
120
140
160
180
29/ 12/ 1989 29/ 12/ 1992 29/ 12/ 1995 29/ 12/ 1998 29/ 12/ 2001 29/ 12/ 2004
Hedging 7
Rising InstabilitiesRising InstabilitiesRising InstabilitiesRising Instabilities1990-1994 2000-2004
mean median mean median
DJ 38.6 27 159.4 199
S&P 500 52.1 36 156 176
FTSE 53.9 57 158.9 174
Commodities 57 52 123 124
USD 106.5 100.5 134.4 138
Hedging 8
Experts’ ViewsExperts’ ViewsExperts’ ViewsExperts’ Views
Bernstein (1996):• Volatilities seems to be proliferating rather than
diminishing.
Krugman (1999):• The world economy has turned out to be a much
dangerous place than we imagined.
Tumpel-Gugerell (2003):• Volatility of leading stock markets has doubled
since 1997. Financial volatility is transmuted into volatility of real output.
Bernstein (1996):• Volatilities seems to be proliferating rather than
diminishing.
Krugman (1999):• The world economy has turned out to be a much
dangerous place than we imagined.
Tumpel-Gugerell (2003):• Volatility of leading stock markets has doubled
since 1997. Financial volatility is transmuted into volatility of real output.
Hedging 9
DerivativesDerivativesDerivativesDerivativesExponential growthControversial impactQuestionable validity
Exponential growthControversial impactQuestionable validity
Hedging 10
0
50,000
100,000
150,000
200,000
250,000
300,000
350,000
Jun-98 Dec.1998
Jun-99 Dec.1999
Jun-00 Dec.2000
Jun-01 Dec.2001
Jun-02 Dec.2002
Jun-03 Dec.2003
Jun-04 Dec.2004
Jun-05
OTC OE
Size of DerivativesSize of DerivativesSize of DerivativesSize of Derivatives
Hedging 11
Structure of DerivativesStructure of DerivativesStructure of DerivativesStructure of DerivativesZero-sum gamesSeparate risk from ownershipAllow hedging only through speculationDominated by speculatorsThreaten system stability
Zero-sum gamesSeparate risk from ownershipAllow hedging only through speculationDominated by speculatorsThreaten system stability
Hedging 12
Market DistributionMarket DistributionMarket DistributionMarket Distribution
Hedging:2.70%
Speculation:97.30%
Hedging 13
Risk DilemmaRisk DilemmaRisk DilemmaRisk DilemmaEconomic activities always involve riskExcessive risk hurdles performancePure risk trading transforms into
wagering
Economic activities always involve riskExcessive risk hurdles performancePure risk trading transforms into
wagering
Hedging 14
Unresolved IssuesUnresolved IssuesUnresolved IssuesUnresolved Issues
Ken Arrow (2003):• Derivatives can be used to reduce risk but
people gamble on them.• Speculators are adding to the swings rather
than reducing them.
Ken Arrow (2003):• Derivatives can be used to reduce risk but
people gamble on them.• Speculators are adding to the swings rather
than reducing them.
Hedging 15
Unresolved Issues…Unresolved Issues…Unresolved Issues…Unresolved Issues…
Kreitner (2000):• No analytical formula could distinguish
gambling from risk allocation.• The question of gambling was eventually
swallowed and internalized, as if the problem were solved.
• The contract law stopped worrying and learned to love risk.
Kreitner (2000):• No analytical formula could distinguish
gambling from risk allocation.• The question of gambling was eventually
swallowed and internalized, as if the problem were solved.
• The contract law stopped worrying and learned to love risk.
Hedging 16
The ChallengeThe ChallengeThe ChallengeThe ChallengeHow to have hedging without
unproductive speculation?How to distinguish legitimate risk
taking from gambling?Where to draw the line?
How to have hedging without unproductive speculation?
How to distinguish legitimate risk taking from gambling?
Where to draw the line?
Hedging 17
Islamic FrameworkIslamic FrameworkIslamic FrameworkIslamic FrameworkAcceptable risk (ex ante):
• Minor, likelihood of success is high• Inevitable, inseparable from real activities
Payoff structure (ex post):• Non-zero-sum-game
Acceptable risk (ex ante):• Minor, likelihood of success is high• Inevitable, inseparable from real activities
Payoff structure (ex post):• Non-zero-sum-game
Hedging 18
Statistical MeasureStatistical MeasureStatistical MeasureStatistical MeasureExpected utility is a statistical meanAllows for gamblingStatistical median:
• Excludes low probability events• Immune to outliers• Consistent with Islamic concept of gharar
Expected utility is a statistical meanAllows for gamblingStatistical median:
• Excludes low probability events• Immune to outliers• Consistent with Islamic concept of gharar
Hedging 19
Payoff StructurePayoff StructurePayoff StructurePayoff StructureZero-sum games: conflict of interestPositive sum games: cooperativeNon-zero-sum games: mixedMixed games are acceptable if the
positive outcome is dominant
Zero-sum games: conflict of interestPositive sum games: cooperativeNon-zero-sum games: mixedMixed games are acceptable if the
positive outcome is dominant
Hedging 23
Product DesignProduct DesignProduct DesignProduct DesignMixed games allow risk transfer with
win-win outcomeCombine best of both worlds
Mixed games allow risk transfer with win-win outcome
Combine best of both worlds
Hedging 24
Islamic Product DevelopmentIslamic Product DevelopmentIslamic Product DevelopmentIslamic Product DevelopmentStrategies for product developmentImitation dilutes valuesIslamic finance becomes a follower
Strategies for product developmentImitation dilutes valuesIslamic finance becomes a follower
Hedging 25
Hedging InstrumentsHedging InstrumentsHedging InstrumentsHedging Instruments
Instrument Risks HedgedAsset-Liability alignment General
Delta-hedging General
Mutual hedging General
Bilateral mutual adjustment Rate of return
Conditional mudharabah Capital, misreporting
Combining musharakah and deferred sale
Capital, rate of return
Third party hedging Capital, rate of return
Diversified deferred price Capital, rate of return, liquidity
Value-based hybrid salam Capital, rate of return, liquidity
Hedging 26
Natural HedgeNatural HedgeNatural HedgeNatural HedgeAlign costs and revenuesShift some operations to the same
regionBorrow in the same currency
Align costs and revenuesShift some operations to the same
regionBorrow in the same currency
Hedging 27
Cooperative HedgeCooperative HedgeCooperative HedgeCooperative HedgeNon-profit arrangementsNo legal guaranteeRisk is shared by membersSuite all kinds of risks
Non-profit arrangementsNo legal guaranteeRisk is shared by membersSuite all kinds of risks
Hedging 28
Bilateral AdjustmentBilateral AdjustmentBilateral AdjustmentBilateral AdjustmentMurabaha cannot have a changing rateAdjust installment but keep total debt
fixed• If market rate is up: increase installment,
reduce balance• If market rate is down: reduce installment,
increase balance• Done with mutual agreement
Murabaha cannot have a changing rateAdjust installment but keep total debt
fixed• If market rate is up: increase installment,
reduce balance• If market rate is down: reduce installment,
increase balance• Done with mutual agreement
Hedging 29
Diversified Deferred PriceDiversified Deferred PriceDiversified Deferred PriceDiversified Deferred PriceAlso for murabahaHave the price in two components:
• Principal: in money• Markup: in liquid assets
Allow return to adjust to marketIf markup is large, total price becomes
tradable
Also for murabahaHave the price in two components:
• Principal: in money• Markup: in liquid assets
Allow return to adjust to marketIf markup is large, total price becomes
tradable
Hedging 30
Parallel MurabahaParallel MurabahaParallel MurabahaParallel MurabahaReplaces currency forwardsIntegrates currency hedge with goods
tradedMurabaha can be for financing or for
hedgingIntegrates risk transfer with value-
creation
Replaces currency forwardsIntegrates currency hedge with goods
tradedMurabaha can be for financing or for
hedgingIntegrates risk transfer with value-
creation